Losing AAA – what would it mean for bank interest rates?

Previously in BlueNotes, I argued there may be more upside than downside for government policy and the economy in a downgrade. However would it matter to businesses and home owners by flowing through to higher interest rates?

"A sovereign downgrade would probably see a raft of corporate downgrades."
Narayanan Somasundaram, Economics & finance reporter

A potential credit rating downgrade for Australia while headline-making has only been flagged by one of the three agencies: Standard & Poor’s. The other two, Moody’s Investors Service and Fitch Ratings Agency, have Australia stable.

If, however, Australia’s rating was given a haircut (and at AA+ it would still be among the highest in the world) then there would be implications for individual companies, including banks, because the agencies typically rank such entities a subordinate to the sovereign. So a sovereign downgrade would probably see a raft of corporate downgrades.

That, in theory, should lead to higher funding costs. Still in a world flooded with central bank liquidity and ultra- low interest rates, it would be at best a small increase.

The funding markets are like all markets, they operate on relativities, on risk versus reward. Australian banks are well regulated, well capitalised and even at the A+ category would remain competitively positioned relative to global peers.

Globally, there are only a handful of banks rated AA- or better with a stable outlook like the major Australian banks. Moreover, it is important to recognise bank funding is a dynamic portfolio.

WHOLESALE

A downgrade would immediately impact only long term wholesale debt. Funding sourced from deposits would not be affected and deposit funding makes up more than two thirds of the funding base.

Term debt is generally issued with an average maturity of around five years and will take time to work its way through. For example a 20 basis point increase in the cost of term wholesale debt would ultimately require around a 5 bps increase in pricing for each loan.

More significantly than funding costs under incoming post-financial crisis regulation will be the concept of total loss absorbing capital (TLOC). This is the capital banks will be required to hold to whether economic downturns and a spike in bad debts.

This regime is independent of government ratings. Rating agencies will not give banks any significant benefit at either AAA or AA+.

It is the capital required for the TLAC regime which is much more likely to drive up funding costs – under some estimates by more than would be likely upon a sovereign downgrade.

Australia’s largest lenders - Australia & New Zealand Banking Group, Commonwealth Bank of Australia, National Australia Bank and Westpac Banking Corp - rely on offshore bond markets for a fifth of their funding requirements, central bank data show.

Consider one scenario, outlined by bank analysts at Citigroup. If bank rankings were lowered after a sovereign downgrade, Citi estimates an increase in borrowing costs of as much as 20 basis points.

While that could prompt the banks to raise rates by a similar clip if not more, it is not all bad news for borrowers. Here’s why.

First, interest rates both for home owners and businesses are near a record low, so a marginal increase will not lead to stress. Second, the chance of another rate cut by the Reserve Bank of Australia this year still remains real.

Third, competition has only multiplied. And finally bond spreads – that is, the cost of borrowing - while higher than maturing short-term debt (current interest rates) are still up to 50 basis points lower than in 2012.

In short, if borrowing costs for consumers and business do go up, it will be from a much lower base.

Banks will see “little margin pressure from wholesale funding costs,” according to Morgan Stanley analysts led by Richard Wiles.

“Margins are an important earnings driver in fiscal year 2017 earnings, but we think the main sources of downside risk are competition, the impact of lower interest rates and term deposit margin squeeze,” he said.

The analysts did warn a downgrade of the Australian credit rating may reduce access to credit markets or raise costs.

PRICED IN

"We don't think it would be disastrous for them, though it would be another challenge for the domestic financial system," QIC head of credit research and strategy Phil Miall told Fairfax Media when rating concerns were peaking.

"In terms of the impact on major bank wholesale funding cost, it's hard to put an exact figure on it. It would be fair to say five-year funding spreads would increase by more than 20 basis points.”

“The key question is, can they fund at a reasonable level? We think the answer is likely to be yes they can, although there would probably be some volatility initially. It probably won't be a major stress but it would be another pressure that contributes to further out-of-cycle lending-rate moves independent of the RBA."

S&P lowered Australia’s AAA credit rating outlook to negative from stable on July 7, after the current conservative government was re-elected with a thin majority. S&P said the election win wasn’t strong enough to allow for forceful fiscal policy measures to curb budget deficits. 

So why does a sovereign rating cut matter for the well capitalised and profitable banks?

Ratings agencies and most investors layer sovereign ratings over the credit ratings of individual firms.

In all but the rarest of cases, no company can have a higher rating than the country in which it is domiciled. That hierarchy cascades and consequently a drop for Australia may mean a similar review for the banks.

In fact, S&P has already reduced the rating outlook on the four largest banks because their credit scores are perceived to benefit from government support. The rating agency also said it expected to lower the lenders in the event of a sovereign downgrade.

Again, the other two agencies have not taken the same action.

Banks already struggling with net interest margins, a measure of lending profitability, at an eight-year low have passed on some higher funding costs to customers. For instance, all of them have raised mortgage rates to landlords this year.  Yet with politics of banking their ability to do so in the future is becoming increasingly constrained.

Still, any rate increase would only lift lending rate from a near record low and further reductions in the cash rate by the central bank could quickly rein it back.

Macquarie Group, JPMorgan and Capital Economics are among those forecasting a 1 per cent cash rate in 2017 from 1.5 per cent now.  Deutsche Bank, Morgan Stanley and AMP Capital are predicting the cash rate will slip to 1.25 per cent.

So, will higher interest rate spook borrowers? If current behaviour is any indicator, they are taking it in their stride.

Investor housing credit rose 0.8 per cent in December, according to the Reserve Bank of Australia - the largest monthly increase since June 2015. Business credit climbed 1.1 per cent from the previous month, the sharpest increase in 15 months, the data show.

Further, 25 basis points increase on a 30-year $A300,000 home loan would only add $A62 to the monthly interest payment, according to a loan repayment calculator on a leading bank’s website.

That put in the broader context is an increase borrowers may be able to stomach.

“With an abundance of global liquidity, wholesale funding costs for highly rated Australian bank paper remains relatively well supported,” Macquarie Group’s bank analyst Victor German said.

“Although risks associated with a potential sovereign downgrade are difficult to quantify, assuming current funding conditions persist into fiscal 2017, we don’t expect to see a material impact on banks’ margins from wholesale funding costs.”

Narayanan Somasundaram is an economics and finance reporter formerly with Bloomberg.